Causes of Inflation

• Prices are pulled up by high demand
• Occurs when aggregate demand increases faster than the economy's productive capacity
• Prices increase when quantity demanded exceeds quantity supplied
• As demand continues to increase, the prices of goods are pulled even higher
• Can result from an increase in the money supply or an increase in the use of credit
  • When the Federal Reserve System increases the supply of money and credit, aggregate demand increases as consumers, businesses, and governments purchase more goods
  • Spending exceeds the available supply of goods ---> demand-pull inflation results

• Prices are pushed up by high production costs
• Occurs when producers raise prices to cover higher resource costs
• Producers must set prices high enough to cover their costs and to earn a profit
• Can be caused by a supply shock:
  • An event that increases the cost of production for all or many firms, resulting in overall higher prices
  • Crop failures, natural disasters, and political upheavals can cause supply shocks
• Caused by the wage-price spiral:
  • a cycle that develops when increased wages raise production costs, which then lead to higher prices for goods and services

• When consumers expect prices to increase, they tend to buy immediately to take advantage of lower prices ---> aggregate demand increases ---> inflation rises
• When consumers expect future prices to be lower, they are likely to postpone buying ---> aggregate demand decreases ---> inflation slows
• When producers expect inflation to increase, they raise prices. As prices continue to rise, consumers' and producers' expectations of future inflation grow even more, and prices spiral upward

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